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Harness Software’s Continued Strong Growth With These Stocks In Your Portfolio

The global software industry has become a mammoth force in the world economy. Industry revenues are estimated to be more than $500 billion in 2021 and the industry is forecast to grow +10% from 2021 to 2028. By any measure, software is one of the top secular growth industries and should be included in any growth stock investor’s portfolio.

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The COVID-19 pandemic caused a surge in software spending in areas such as communications and ecommerce. The emergence of the “work from anywhere” phenomena has stressed corporate networks and increased the need for cybersecurity. Companies in these areas saw an associated spike in demand and sales last year. Global lockdowns resulting from the pandemic also stimulated demand for video games, many of which are played and delivered entirely online. In 2021, many back-office areas of business software, including ERP and CRM products, should see a pickup as economies re-open. The emergence of virtual implementations, particularly of cloud-based software-as-a-service (SaaS) offerings, should also help sales and deployment this year. 

Despite this strong growth, the software sector as a whole is not overly expensive relative to its history.  The IGV, the software ETF comprising 124 stocks that acts as a proxy for the overall industry, is forecast to grow revenues +16% and EPS +10% in FY22. 

The industry is presently valued at 10.7x FY22 sales, in line with its long-term average. In addition, the software industry’s shift from perpetual or term license sales to a subscription model has meaningfully increased revenue stability. The percentage of software industry revenues from subscriptions rose from 36% in 2005 to 70% last year. I expect investors will reward this increased sales stability with a continued premium valuation for the industry.

Despite a tough upcoming comparison with June 2020 results, which could result in a slightly down Q2 2021 in terms of EPS for some software groups, full-year 2021 results are expected to be solid. Five sub-groups (Design, Desktop, Enterprise
AAXN
, Gaming, and Security) are expected to produce double-digit median revenue and EPS growth. Enterprise is expected to top the list with a median of 27% revenue and 18% EPS growth.

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Investors are uncertain in the short run whether value stocks, driven by the economy’s recovery from COVID restrictions, or growth stocks, driven by low interest rates and a possible slowing of growth in 2022, will dominate the equity markets over the next three years. However, given its strong secular growth, the software industry should perform well. I believe investors should increase their exposure to software, and I’d like to highlight a few stocks with both strong fundamentals and positive technical setups.

Adobe
ADBE
(ADBE; $290B market cap) is an enterprise provider of marketing solutions, including design, imaging, and publishing software. A secular shift to digital and social media marketing is driving expansion in its total addressable market (TAM), which is estimated to reach $147B by 2023 from $108B in 2021. A key metric for Adobe is annualized recurring revenue (ARR), which continues to grow 20%+ more than seven years after the company shifted from a license model to SaaS in 2013. In its Q2 results, Adobe reported a beat-and-raise quarter with better-than-expected results for all important metrics. Its largest segment, Digital Media (73% of total), grew revenues 25% y/y, led by Document Cloud (+30% y/y) and Creative Cloud (+24% y/y). Digital Experience (24% of total) revenues were up 21% y/y and Publishing and Advertising (3% of total) revenues were down 10% y/y. For FY21, Adobe expects revenue of $15.5B (+18% y/y and above estimates of $15.2B) and EPS of $11.9 (+11% y/y and above estimates of $11.3). The company expects digital media revenue growth of 22% and digital experience revenue growth of 20%. In terms of valuation, ADBE is slightly cheaper than the IGV, with 2022 EV/S 10.2x and EV/EBITDA 31.4x, versus the IGV (median) of EV/S 10.7x and EV/EBITDA 32x. The stock rallied for seven consecutive weeks after breaking out of a 40-week consolidation in June and is currently about 14% above that pivot of $537. Its first support is at the rising 21-DMA.

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DocuSign (DOCU; $58B market cap) provides cloud-based electronic signature solutions. Since its IPO three years ago, its TAM has doubled to $50B, mainly driven by expansion via acquisitions into eNotary, Contract Lifecycle Management (CLM), and Insight (Contract Analytics). As a rare software name to come to the market already profitable, DocuSign has since sustained excellent growth, with a five-year revenue CAGR of 40%, compared with 22% for its main competitor ADBE (Adobe Sign). The primary overall growth driver is a seven-year customer CAGR of 37%. As of Q1 2021, total customer count jumped 50% to 988K and in May surpassed 1M. Net dollar retention rate accelerated to 125% (+600bps y/y). The company sees 40% growth in revenues and double-digit operating margins for 2021, implying margin expansion of ~460bps. DOCU is expensive, at EV/S 26.7x and EV/EBITDA 119.4x, compared with EV/S 10.7x and EV/EBITDA 32x for the IGV (median). However, it is profitable and likely growing EPS at least 30% for the next two years. It is currently pulling back on light volume toward the pivot range ($290–306) from a 43-week consolidation, which it broke out of in June.

Microsoft
MSFT
(MSFT; $2.1T market cap) is an enterprise software provider. Despite its size, all three major segments grew revenue and operating income by double digits in Q3 FY21 (March). Productivity (~35% of total) revenues and OI were up 15% and 25%, respectively, with growth led by Dynamics 365 and Linkedin; Intelligent cloud (~35%) revenues and OI were up 23% and 41%, respectively, with growth led by Azure (despite the U.S. Department of Defense cancelling the JEDI contract, Azure is growing faster and gaining ground on industry leader AWS); Personal Computing (~30%) revenues and OI were up 18% and 27%, respectively, with growth led by gaming/Xbox. The company sees double-digit revenue and OI growth for the full year (ending June). Q4 results are due this week (July 27). I am extremely bullish on the company’s recent $16B acquisition of Nuance
NUAN
Communications, its second largest acquisition after LinkedIn ($26B) in 2016. Nuance provides AI-based voice and speech recognition for multiple end-markets, including health care, telecommunications, and financial services. MSFT is cheaper than the IGV based on 2022 outlook, with MSFT at EV/S 10.5x and EV/EBITDA 21x and the IGV (median) at EV/S 10.7x and EV/EBITDA 32x. The stock is rising along its 21-DMA after breaking out of an eight-week base in June.

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Crowdstrike
CRWD
(CRWD; $58B market cap) provides cybersecurity solutions, initially focusing on end-point security but rapidly expanding into new areas, including corporate workload, threat intelligence, and vulnerability management. Its TAM is expected to grow to $106B by 2025 from $36B in 2021, a four-year CAGR of 31%. Just as important, annualized recurring revenue (ARR) will jump from $1B currently to $3B by 2025, a four-year CAGR of 32%. This is extremely conservative based on historical customer growth. In early June, the company reported a beat-and-raise quarter, with KPIs (ARR, customer growth, retention rate) all better than expected. Its calculation is rich but explained by the recent turn to adjusted EPS positive and extremely fast forward growth projections. Based on 2022, CRWD is valued at EV/S 32x and EV/EBITDA 220x, compared with the IGV (median) at EV/S 10.7x and EV/EBITDA 32x. The stock is at a pivot after breaking out of an 18-week consolidation in June; its first level of support is the rising 50-DMA.

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While leadership in the U.S. market has swung between Value and Growth this year, the trends propelling the software industry’s strong secular revenue and profit growth means that software stocks should be rewarding investments over the next several years. These names represent some of the leaders in this dynamic space and I encourage investors to consider them for their portfolio.

Kenley Scott, Director, Global Sector Strategist and Cornelio Ash, Director, Research Analyst at William O’Neil + Company, an affiliate of O’Neil Global Advisors, made significant contributions to the data compilation, analysis, and writing for this article.

DISCLOSURE:

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No part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed herein. O’Neil Global Advisors, its affiliates, and/or their respective officers, directors, or employees may have interests, or long or short positions, and may at any time make purchases or sales as a principal or agent of the securities referred to herein.

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